by Marc Lichtenfeld. Chief Income Strategist, The Oxford Club Wednesday, May 4, 2011 Income

by Marc Lichtenfeld. Investment U ‘s Senior Analyst

Wednesday, May 4, 2011: Issue #1505

There’s an old saying; when the going gets tough, the tough buy consumer staples stocks — or something like that. Historically, the sector has been viewed as a defensive position. It makes sense. Even if the economy stinks, you’re still going to brush your teeth, use the toilet and feed your kids (at least I hope you are).

In the past year, the consumer staples sector, as measured by the Consumer Staples Sector SPDR (NYSE: XLP ), is up 14.9 percent, outperforming the S&P 500’s rise of 13.6 percent. John Roque, Managing Director at WJB Capital, points out that consumer staples and the S&P 500 are closely correlated. When consumer staples stocks are strong, the S&P 500 tends to follow suit.

To see the chart in its original size, click here . Source: WJB Capital

But now with inflation rising, some investors are getting scared away from consumer staples. They believe the higher costs are going to pinch margins and will drive consumers to cheaper private label brands.

Investors Are Wrong About Consumer Staples Future Strength

Those investors are wrong. Consumer staples should remain strong in the foreseeable future.

While commodity and raw material costs are climbing, consumer staples companies are passing those costs along to customers. Last week consumer products giants Procter & Gamble (NYSE: PG ) and Kimberly-Clark (NYSE: KMB ) said they were each raising prices on diapers by as much as seven percent. On Monday, Colgate-Palmolive (NYSE: CL ) suggested it would also lift prices on some of its products.

And while some would argue that rising prices will push consumers to less expensive store brands, it’s important to remember that many of the large consumer brand manufacturers are putting the same products in plainer wrappers and selling them as generic brands. The margins might be a little lower, but the manufacturer is still capturing the sale.

For example, Ralcorp (NYSE: RAH ), the maker of Post cereals, also makes 50 store brand cereals that are comparable to the national brands in terms of taste, appearance and nutrition. That’s because it’s the same stuff. One is in a Post Bran Flakes box and the other is in an IGA (Independent Grocers Alliance) box. The Post box costs more because Ralcorp supports it with advertising, couponing, paying for shelf space and so on. It shares none of those costs associated with the IGA box.

Same cereal, different box.

Consumer Staples Sector Are Still Cheap

Although the consumer staples sector has rallied over the past year, the stocks are still cheap by historical standards. As you can see in the chart below, eight of the top 10 holdings of the XLP are trading with price-to-earnings ratios that are lower than their 10-year average. As a group, the stocks are trading 17 percent below their 10-year average.

To see the chart in its original size, click here .

As a whole, the 10 stocks are trading slightly below the S&P 500’s 16.1 P/E ratio.

On a forward PE basis, they’re trading at just 13.7 times earnings, also below the S&P 500.

Additionally, these 10 stocks have an average dividend yield of 2.9 percent, significantly higher than the 2.1 percent yield of the S&P 500. While 2.9 percent is not an especially robust yield, it’s solid for today’s low-interest-rate environment. The stock prices also aren’t subject to the whims of madmen in foreign lands the way energy stocks and gold stocks are (although gold might be more tied to madmen in our own country).

Consumer Staples — An Undervalued Sector With Above-Average Yield

The consumer staples group represents an undervalued sector with an above-average yield during a period that suggests further market gains are likely.

But should stocks correct, as you can see from the first chart, consumer staples stocks tend to suffer less severe declines than the broader market. They’re a unique way to play offense and defense at the same time.